CORPORATE INCOME TAX RATES

 

Just a reminder.  Regardless of the rate charged - corporations do not pay federal or state income tax.

Income tax is a corporate expense – a part of overhead.  Income taxes paid by a corporation are included in the price charged to customers and clients for goods and services.  And it could also reduce the amount paid out as dividends to shareholders.  So, the individual consumer/investor ultimately pays 100% of all corporate income tax either by increased prices or reduced dividends.

I have always believed corporations should have a “dividends paid” deduction – corporations should be able to deduct from taxable income dividends paid to shareholders.  If this were instituted there would be no need for special lower tax rates for qualified dividends (although the lower rates would remain for long-term capital gains) – all dividends would be taxed as ordinary income – and really no need for Section 199a.  

And, of course, all industry-specific or general corporate loopholes and special deductions and credits should be repealed.

Am I wrong in my thinking on either issue?

TTFN

WHEN CHOOSING A BUSINESS ENTITY DON’T FORGET FICA TAXES

An often-overlooked issue when deciding on the type of entity to choose to operate your one-person or closely-held business is the FICA or FICA-equivalent tax (self-employment tax).

If you operate as a sole-proprietor, filing a Schedule C, (or as a partnership) your FICA-equivalent self-employment tax is calculated on net earnings from self-employment BEFORE deducting health insurance premiums and retirement plan contributions.

The net amount on your Schedule C is $100,000.  You also deduct $24,000 in self-employed health insurance and a $15,000 contribution to your SEP retirement plan as adjustments to income.  So, your net “out of pocket” is $61,000.  Your self-employment tax is $14,130 - $100,000 x .9235 = $92,350 x 15.3% = $14,130.  The Schedule C filer is entitled to a tax deduction, as an “adjustment to income”, of $7,065 for half of the self-employment tax.

If you operate as a corporation and take $55,000 as a salary your FICA tax is $4,207.50 - $55,000 x 7.65% = $4,207.50.  The corporation matches this and also pays $4,207.50, so the total cost is $8,415.  As a corporation you are $3,000 -$5,000 less (the $5,715 in reduced FICA tax less the tax savings you would have received from the self-employment tax adjustment to income) out of pocket.

If the business has a $100,000 net gain, as per the Schedule C, and pays out $55,000 in wages, $39,000 in employee benefits (the owner’s health insurance premiums and pension contribution) and $4,208 in FICA tax the net taxable income of the corporation is $1,792.  The federal corporate income tax if a “C” corporation is $376.  If it is an “S” corporation the taxpayer may be allowed an additional $358 “Section 199a” deduction and pay federal income tax as an individual on $1,434 - $315 for a taxpayer in the 22% bracket.

Clearly the Schedule C filer pays substantially less in FICA-equivalent taxes than the corporation pays in FICA taxes.

However, regarding the 20% Section 199a deduction – for a “C” corporation there is no deduction allowed, for the “S” corporation the deduction is on the net business income reported on K-1 and does NOT include the sole-shareholder’s wages, but for a sole-proprietorship filing a Schedule C the deduction is allowed on the net amount reported on Schedule C less the adjustments to income for self-employment tax, self-employed health insurance and retirement income contributions.  In the above example the taxpayer’s “Qualified Business Income” (QBI) eligible for the 20% deduction is $53,935 - $100,000 less $24,000 less $15,000 less $7,065 = 53,935 – which could result in a deduction that reduces net taxable income by $10,787.

So, a Schedule C filer could pay less federal income tax on his or her net “in pocket”.

Obviously, the payroll tax cost, or the QBI deduction, is not the only consideration to be reviewed when choosing a business entity.  There are additional filing and administrative costs associated with operating as a corporation – when creating the corporation, during its operation, and when terminating/dissolving it.  There will probably be additional state payroll tax costs – unemployment, disability and/or family leave insurance contributions – and may be required worker’s compensation insurance premiums for the owner being paid as an employee that would not exist for a sole-proprietor.  And the management and administration of a corporation is more time consuming and requires more detailed recordkeeping and federal, state and local government filings.

As a point of information – operating as a corporation provides the owner with “limited liability”, but so does registering your Schedule C sole-proprietorship as a “Limited Liability Company” (LLC).  And if you are an LLC you can file your taxes as either a sole proprietor on Schedule C (or as a partnership if more than own owner) or a corporation, either “C” or “S”.

In terms of the Social Security component of the FICA payroll tax, paying the tax on a lower earnings base may affect the benefits you receive when you begin to collect.  In the above example the Social Security earnings for the Schedule C filer is $92,350, but is only $55,000 for the corporate employee.  Social security benefits are based on your 40 highest-earning years.  FYI - there is a maximum wage/earnings cap on the Social Security component of FICA tax, which applies to both wages and net earnings from self-employment.

What I am saying is that choosing a business entity is a serious and complicated matter involving many important issues – both tax and non-tax.  There is no “one size fits all” answer – regardless of what a lawyer may tell you.  When deciding on the entity you should consider the difference in payroll tax costs, and now under the GOP Tax Act the potential savings from the Section 199a QBI deduction.  Do multiple calculations based on various amounts of anticipated income.

And consult a tax professional BEFORE you consult an attorney!

TTFN

IRS DRAFT 2018 FORMS

We have already seen the IRS draft of the stupid new 2018 Form 1040 “postcard” andits 6 new supplemental statements.  The IRS has now also issued draft copies of the 2018 Schedule A and Form K-1s for partnerships and S-corps and the instructions for the 2018 Form 1040.

The 2018 Schedule A section for “Taxes You Paid” begins with “State and local taxes”.  There are lines for income taxes or general sales taxes, real estate taxes and personal property taxes.  The wording and format for indicating if you are claiming state and local sales tax instead of state and local income tax has changed, but the option still exists.  After entering amounts for these three items and coming up with a total there is a line that says “Enter the smaller of line 5d {total taxes claimed – rdf} and $10,000 ($5,000 if married filing separately).”  Here is where the new limitation is applied.   

This section also contains a line for “Other taxes” that is after the application of the $10,000 limit, which indicates that these taxes are deductible in addition to the $10,000.  I am curious to read the instructions to find out what “other taxes” they are talking about.   In the past I have put employee withholding for state unemployment, disability and family leave contributions, but these taxes are really part of state and local income taxes and are included in the $10,000 limit.

The “Interest You Paid” section includes a new box to check under the line for “Home mortgage interest and points” if “you didn’t use all of your home mortgage loan(s) to buy, build, or improve your home”, referring the taxpayer to the instructions.  Here is where you must indicate if you have any home equity debt.  I cannot stress enough how the elimination of the deduction for home equity interest affects the preparation of the Schedule A. 

There is also a line identified as “Reserved”, which has been suggested exists because the IRS thinks the idiots in Congress may reinstate the inappropriate deduction for mortgage insurance premiums for 2018 before the end of the year.

The “Casualty and Theft Losses” category line identifies the new limitation of the deduction to “casualty and theft loss(es) from a federally declared disaster”.

The entire “Job Expenses and Certain Miscellaneous Deductions” section is gone, as these items are no longer deductible.  And the “Total Itemized Deductions” section no longer asks if your AGI is over the former Pease threshold, as the phase-out of itemized deductions no longer exists.

I am truly eager to see the draft of the instructions for Schedule A for many reasons, including the explanation of what is deductible as gambling losses.  There has been conflicting advice and information provided by tax preparation CPE providers.

All the discussions of the unnecessary new Section 199a deduction mention that the K-1s from partnerships and sub-S corporations will be reporting important information related to this deduction.  But the draft K-1s for 2018 do not look any different than those of past years.  Perhaps the information will be included in “See attached statement for additional information”.  I certainly hoped, and had assumed from what I had been taught at GOP Tax Act CPE sessions, that the front page of the K-1 would specifically address the Section 199a deduction requirements.

I have very briefly skimmed the 1040 instructions, but have not reviewed it in any detail yet.  I did, however, check to see and found that it does include a "Simplified Worksheet" for calculating the Section 199a deduction.  

I will let you know as more draft forms with GOP Tax Act changes are released.

TTFN

THE SECTION 199a DEDUCTION MAKES NO SENSE

The new “Section 199a” deduction – 20% of pass-through business income - created by the GOP Tax Act makes absolutely no sense.

Why does it exist?  The Act reduces the tax rate on regular “C” corporations to 21%. Pass-through businesses – sole proprietors filing Schedule C, partnerships and sub-S corporations – had paid tax on net business income at “ordinary income” rates, as much as 37% under the new rate schedule.  So to make the reduced C corporation rate more palatable Congress felt it had to throw pass-through businesses a bone.

But are C corporation net profits really taxed at only 21%.  A corporation will pay 21% tax on its profits.  When the profits are paid out to shareholders as dividends the individual shareholders include these dividends as income on their personal tax returns.  This is the classic “double-taxation” of corporate dividends.  Qualified dividends are taxed at a lower rate – 0%, 15% or 20%.  Plus, dividends, being investment income, can also be subject to the Obamacare 3.8% surtax.

A taxpayer in the 22% bracket will pay 15% tax on the qualified dividends received.  So, the corporate income represented by the dividend distribution is actually taxed at 36% - 21% and 15%.  If the same taxpayer received the dividend income as a pass-through from a sub-S corporation the tax on $100 would be $18 ($100 - $20 = $80 x 22% = $17.60), or only 18% - half the effective tax on C corporation income.

A person in the top tax bracket would pay 23.8% tax on the dividends – the 20% capital gain rate and the 3.8% Obamacare surtax.  So, the corporate profit would be effectively taxed at 44.8%.  Sub-s pass through income could be taxed at as much as 40.8% (the 20% deduction may not be available).   

Here is what I say should be done.

C corporations should be allowed to claim a tax deduction for “dividends paid” and only pay corporate income tax on the actual “retained” earnings.  Dividends would continue to be taxed on the income tax returns of shareholders.  But since there is no longer any “double taxation” there would no longer be a need for a special tax rate on dividends.  There would be no 20% Section 199a deduction.  So, monies passed through to business owners – either as corporate dividends or pass through business income – would all be taxed at ordinary income rates. 

The inequity in the treatment of corporate income and self-employment income from sole proprietorships and partnerships exists not in the income tax treatment but with the application of the FICA-equivalent “self-employment tax”.  A person who owns a corporation pays himself/herself a salary, subject to FICA tax. The employee pays half the tax and the employer pays half the tax.  The net profits distributed to the owner is in the form of dividends, or sub-S pass through income, which is not subject to self-employment tax.  Employee benefits, such as health insurance premiums and employer pension plan contributions, are not subject to FICA tax.

A sole proprietor and general partner pays self-employment tax – the equivalent of both halves of the FICA tax – on the total amount of “net earnings from self-employment” which is the total net profit reported on Schedule C or the total business income pass through for the general partner, adjusted for half the s-e tax, before any deductions for health insurance premiums or pension contributions.  A large portion of the net earnings from self-employment for sole proprietors and general partners is “wage-equivalent”, but a portion is also “dividend-equivalent”.  

First, health insurance premiums and pension contributions (with the possible exception of the equivalent of 401(k) deferrals) for the self-employed person should be allowed as a deduction in determining net earnings from self-employment.  And only a percentage of the net earnings from self-employment, the percentage representing wage-equivalent earnings, should be subject to the self-employment tax.  It is truly difficult to determine the appropriate allocation of net income to wage earnings and return on investment dividends.  Perhaps using an arbitrary allocation, like 70% wage-equivalent and 30% dividend-equivalent, is the simplest way to go. 

FYI I would also do away with ALL industry-specific loopholes, deductions and credits for ALL business activities, basically taxing ALL business entities on net book profit.  

What do you think?

TTFN

A LITTLE THIS-A, A LITTLE THAT-A

+ I owe an apology to McDonald’s, Burger King, Wendy’s, Taco Bell, etc. for using them in a description of Henry and Richard and other commercial tax return mills of that ilk.

I have always said that H+R et al “charge gourmet restaurant prices for fast food service”.  Basically, I am observing that Henry and Richard, and the others, ain’t cheap, or even reasonable, and the fees are certainly not commensurate with the service.  But comparing the service at tax preparation chains to that received at fast food chains is not fair – nor true.

Prior to being diagnosed with diabetes I was a frequent patron of McDonald’s, Burger King and Wendy’s.  For the most part, I found the service provided by these chains to be most definitely “appropriate”.  And, again for the most part, I most certainly received value for my money. 

Those who use tax preparation chains will NOT be able to say the same thing when describing their experience.

And I must point out that nobody at McDonalds, Burger King or Wendy’s tried to force me to buy fries or onion rings that I neither wanted nor needed.

So, more appropriately, H&R et al “charge gourmet restaurant prices for service that is inferior to the service you get at a fast food chain.”

Of course, to be fair, I must always include in my assessment of tax preparation chains the following statement –

It may actually be possible that the best tax preparer, at the best price, for your particular situation is an H+R Block, or other chain, employee.  But this is only because of the individual education, experience, ability, temperament, and other factors that are specific to that individual preparer or perhaps that unique and specific franchisee.

Hey, it is better to be safe than sorry.  Bottom line - don’t use Henry and Richard or another chain to have your 2017 income tax returns prepared.  If you are looking to find a tax pro you can start here.

+ Hey fellow tax pros – did you see Monday’s post at THE TAX PROFESSIONAL?

+ This past Sunday was the first payroll I processed for a business client using the new tax withholding tables that were revised to reflect the changes of the GOP Tax Act.  I was curious to see if employees were actually getting any more money in their paychecks.

The gross payroll – total wages paid - for 20 employees for the 2-week pay period was up about $3,600 from the January 8^th payroll, but the federal income tax withholding was $1,050 less.  So, there actually was more money in the paychecks.

However, the pay checks of the two highest paid employees, including the millionaire owner of the business, with the same gross income for the two payroll periods being compared, were increased by over $750 due to reduced federal income tax withholding.  Obviously, the increases in the paychecks of the lower paid employees were small.

I do worry, being cynical, that the withholding tables are a bit too “generous” to try to prove that serial liar Donald T Rump was telling the truth for once when he said workers would see increased paychecks thanks to the Act.  I expect that, while individual paychecks will be slightly higher, 2018 tax return refunds may be lower, or balances due higher, especially for employees who live in New Jersey, as the employees of the above client do.

I am not alone in my concerns.  In “Democrats raise concerns about IRS withholding tables” at TAXPRO TODAY Michael Cohn tells us (highlights are mine) -

“The ranking Democrats on the tax-writing House Ways and Means Committee and Senate Finance Committee are worried the Internal Revenue Service might succumb to political pressure by releasing withholding tables this year that cause employers to withhold too little in federal taxes from their employees’ paychecks to make it appear the tax cuts are larger than they really are, with the result that taxpayers will end up owing more money on their taxes next year.”

+ Speaking of business clients and the GOP Tax Act, also this past week-end a business client, a family owned “regular” (non-S) corporation with 2 shareholders that usually has net taxable income of under $50,000, asked if its tax will be reduced under the new tax law.

When the lower corporate tax rate was originally discussed I had thought the entire rate scale would be reduced. I think I had read somewhere that those currently paying 15%, based on net taxable income, would pay 8% under “tax reform”. However, everything I have read says the income tax rate in the Act is a flat 21% tax rate on net taxable income for all “regular” (non-S) corporations.

So smaller closely held corporations, with net taxable income of $50,000 or less, who previously paid 15% in federal income tax will actually see a 6% tax increase, and, because the sliding scale of tax rates is gone, those with $75,000 or less in taxable income will see a 2+% increase.

Once again true small business gets screwed!

+ FYI - some guidance from the IRS on one of the changes in the GOP Tax Act.

The weekday daily “Checkpoint Newsstand” email newsletter tells us what it learned from the “Frequently Asked Questions” (FAQs) posted to the IRS website -

“The FAQs clarify that a Roth IRA conversion made in 2017 may be recharacterized as a contribution to a traditional IRA if the recharacterization is made by Oct. 15, 2018. A Roth IRA conversion made on or after Jan. 1, 2018, cannot be recharacterized.”

+ The last word - As with any post, your appropriate comments, and not “praise” that is really only trying to promote your site or product, are always welcomed.  I also want to know if you find any tax law inaccuracies, or typos or other clerical FUs, in the post.

TTFN

THE SPECIAL TAX RATE FOR FLOW-THROUGH ENTITIES REALLY IS A BAD IDEA

I agree with fellow tax pro and tax blogger Peter J.  Reilly, who posts at FORBES.COM “Special Rate For Flow-through Entities Is A Really Bad Idea”.

 

Peter begins by comparing the scribblings on a cocktail napkin that is the current tax “plan” with the initial presentation of tax reform proposals that eventually became the Tax Reform Act of 1986 -

 

“. . . but the elderly curmudgeon in me can't resist reflecting on how comprehensive tax reform was handled in 1986. In 1984, the Treasury issued the two volume, Tax Reform For Fairness, Simplicity, And Economic Growth (Vol. 1. Vol. 2) .  All in it was over 700 pages.  The Unified Framework is nine pages.  Only it kind of looks like the nine pages you would get if a kid were assigned a ten page paper, figured he could get away with turning in nine, but realized he didn't have even nine pages of material and thought of every possible way to stretch it.”

 

He then goes on to address one of the cocktail napkin scribblings, described in the 10-page paper as -

 

“The framework limits the maximum tax rate applied to the business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations to 25%. The framework contemplates that the committees will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.”

 

Pete “first heard about the concept of a special rate for pass through entities about six years ago”.  His response –

 

“I thought then it was one of the stupidest ideas I had ever heard, and continue to think that.”

 

As I said above I also oppose this scribbling from the Trump “framework”.  Small business earnings should not be taxed on the Form 1040 differently from salaries and other “ordinary income”.

 

I do not oppose lowering the corporate income tax rate, although I have suggested a better idea in “Something to Think About”.

 

Regular “C” corporation income is taxed twice – first at the corporate level and second when dividends are distributed to shareholders.  Lower income taxpayers pay 0% tax on “qualified” dividends, so there is some relief from double-taxation, but those with higher incomes pay 15% or 20%.  This is less than the corresponding tax rates on ordinary income, but it is still double-taxation.  Pass-through income from sub-S corporations, as well as self-employment income from partnerships and sole proprietorships, are taxed one time on the Form 1040 as ordinary income.

 

If you work for someone else, including your own C corporation, you receive a W-2 and your wages are taxed as ordinary income.  If you are self-employed, either reporting income expenses on a Schedule C or a partnership return, you do not receive a W-2 and your net income is taxed as ordinary income, and losses reduce ordinary income.

 

If you are a shareholder in a sub-S corporation you receive a W-2 for your salary, or at least should if you are actively involved, which is taxed as ordinary income, and the balance of the corporation’s net income is taxed on your Form 1040, also as ordinary income.  This is true whether or not you actually receive a distribution, the equivalent of C-corporation dividends, from the sub-S activity. 

 

The purpose of the sub-S corporation appears to be primarily to avoid the double-taxation of corporate income for small corporations (to be a sub-S corporation you cannot have more than 100 shareholders).  Before the creation of the LLC it was also a way to get some of the limited liability protection available to corporations for the self-employed, who would otherwise operate as a sole proprietor or partnership with full liability, while maintaining the tax benefits of a Schedule C or partnership.

 

Currently most sub-S corporations are “professional corporations” – those owned by licensed professionals such as attorneys, architects, engineers, accountants, physicians, etc.  Professional “C” corporations pay federal income tax on net income at a flat rate of 35%.  Pass-through income is taxed on the Form 1040 at between 10% and 39.6%, depending on the shareholder’s level of income.  Under existing tax law, the pass-through income from a sub-S professional corporation is often actually taxed at a lower rate than the C corporation flat 35% tax rate.

 

As a kind of funny aside, the IRS takes opposing positions on the “appropriateness” of the salary paid to the owner(s) of a one or few person corporation depending on whether the corporation is a “C” or an “S”.  In the case of a “C” corporation the IRS tries to say that the salary paid is too high, to create dividends that are doubly-taxed.  With a “S” corporation the IRS tries to say that salary paid is too low, to reduce the amount of net profit that is “passed-through” and avoids payroll taxes.

 

For the self-employed sole-proprietor or partner no salaries are paid to owners.  A Schedule C filer and partners pay tax at ordinary income rates on the entire net profit from the business activity – much of which is really the equivalent of W-2 earned income.  But these individuals also get a full tax deduction (although limited in certain situations due to basis and “at-risk”) for a net loss, reducing other income taxed at ordinary rates.  C corporations get to carry back or forward any net losses to reduce net income taxed at C corporation rates.

 

Taxing Schedule C and partnership and sub-S K-1 income at a lower rate could make those who work for someone else pay more tax on their earned income than those who are self-employed.  And the tax differential would most certainly disproportionately benefit higher income taxpayers – those who would be taxed on W-2 income at the new 35% rate.  It is obvious that this would result in higher income taxpayers creating pass-through entities for income that otherwise would be reported as W-2 income to avoid taxes big-time.  

 

Under my corporate tax reform proposal, which calls for a dividends-paid deduction, I would think there would be less need for sub-S corporation status.  There would be no double-taxation to be avoided, and LLC status would provide limited liability protection.

 

As a separate issue, self-employed sole-proprietors and partners are currently treated unfairly in the area of self-employment tax (the equivalent of FICA tax for employees. 

 

If you have a corporation for your self-employment activity you pay yourself a salary, on which you pay FICA tax.  You claim a corporate tax deduction for employer paid health insurance and pension contributions.  If your salary is $100,000 and your health insurance and pension deductions total $25,000 you are only paying FICA tax on $100,000.

 

If you are a sole-proprietor or partner you still get a deduction for your health insurance premiums and pension contributions, but as an “adjustment to income” reducing Form 1040 net taxable income and not as a deduction against self-employment income.  You begin calculating the self-employment tax on $125,000 of income.  So the sole-proprietor and partner will pay more FICA-equivalent self-employment tax than the corporate employee pays FICA tax on the same net income. 

 

Is all this too confusing?  Any questions?  What do you think? 

 

TTFN

 

 

 

 

 

 

 

SOMETHING TO THINK ABOUT

With all the talk about tax reform and reducing the corporate tax rate I have not heard anyone propose a “dividends paid” deduction for corporations.

 

Corporate profits are taxed twice – on the corporate return, and then again on the individual income tax return when dividends are paid to shareholders out of corporate profits.  On the individual level there is some relief via the reduced tax rates on “qualified” dividends – 0%, 15% and 20%.  But, except for the lowest level, there is still double taxation.

 

Instead of reducing the corporate tax rate to 15% why not just allow corporations to deduct from net taxable income dividends paid to shareholders.  And on the individual level tax all dividends as ordinary income, like interest income.  There would no longer be “double-taxation” of corporate income and basic investment income – interest and dividends - would be taxed the same as earned income.

 

On the corporate level I would also suggest removing all industry-specific tax “loopholes”, and tax corporations on net book income less dividends paid.  I would also do away with the deduction for depreciation on real property (buildings) and true capital improvements thereto – both on the corporate and individual tax return.  Generally, in reality, the value of investments in real estate do not “depreciate” over time.

 

Under my suggestion “C” corporate income and pass-through corporate income would be taxed in a similar method.  Dividends paid from a “C” corporation, not taxed on the corporation level, would now be taxed to the shareholder at ordinary income rates, and “S” corporation profits, an equivalent of dividends, would continue to be taxed at ordinary income rates.

 

My proposals would result in both corporations and individuals being taxed on the net “cash in pocket” economic result of their activities.

 

What do you think?

 

TTFN

 

 

 

THIS JUST IN - GOOD NEWS FROM NEW JERSEY!

Miracles can happen!

 

I found the following good news on the New Jersey Division of Taxation website - almost as if it were a response to the comment I made in this morning's earlier post about the NJ-NATP Famous State Tax Seminar (highlights are mine) -

 

“NJ will continue to accept paper corporate business tax returns for the current filing year; however, all corporate payments are required to be submitted electronically.

We are in the process of developing a free filing option for corporate business tax returns so corporations can meet the efile requirement without additional cost. When free file becomes available, the mandate requiring all taxpayers and tax preparers to submit corporate business tax returns and payments electronically, will apply to all corporate taxpayers.”

My clients already gladly make all NJ state payments online - so that is not a problem. 

 

For the first time I can remember I am actually impressed by the NJ Division of Taxation!